Seeing Through the Debt Ceiling

Recurring debt ceiling theatrics often unnerve investors, but they're toothless.

In the pantheon of American political traditions, debt ceiling doom-mongering has a special place. The legislative limit on new debt issuance has historically inspired months of political grandstanding and dire default warnings (including from the media), followed by last-minute agreements raising or suspending the cap. A year or so later, policymakers reconvene and do it all over again. Sound like fun? Then get ready, because after lying dormant since October 2015, the debt ceiling returns today-and with it, the false choice of either raising it or defaulting on US debt. But while the debt ceiling's return may rekindle some old worries, they're as baseless as in previous years, and no threat to this bull market.

When the ceiling takes effect, it'll cap US debt at present levels (about $20 trillion). If Congress doesn't immediately lift or suspend it (unlikely), the Treasury will use "extraordinary measures"[i] to keep all checks flowing for a few months without increasing debt-most estimates say mid to late summer in this case. After that, the popular perception goes, all heck breaks loose. Folks fear the US government would renege on its sacred financial obligations and default; ratings agencies would downgrade America (again), sending foreign creditors fleeing, boosting interest rates on US debt and raising borrowing costs economy-wide.[ii] Hence, many fear markets would plummet, causing general chaos and perhaps another financial crisis.

But this apocalyptic scenario is wildly improbable. Congress has always lifted the limit in the past-all 110 times since 1917. And because of something called "prioritization," even exhausting extraordinary measures wouldn't bring default.

Default means one thing only: missing interest or principal payments on loans. Pols muddy the water by using the fuzzy term "legal obligations," which includes many other types of payments. But this isn't accurate: Default is failing to service debt, full stop. If that weren't the case, than the temporary government shutdowns of the mid-1990s and 2013 would constitute defaults, as certain contractors weren't paid. No one credibly considers that the case. Prioritization prevents default by paying the most important bills-interest on US debt-first when cash runs low, rather than paying each as it comes due.

Past administrations (most recently Barack Obama's), however, insisted prioritization wasn't the answer. During the 2011 and 2013 debt ceiling debates, Treasury officials including former Secretary Jack Lew claimed prioritizing payments was technically impossible-the Treasury's computers were set up only to pay all bills on time, in the order received. In 2011, Treasury Secretary Tim Geithner argued nonpayment of any obligations counted as default, adding that it threatened the Treasury's ability to even roll over the principal, because spooked investors wouldn't buy (at least not at a rate the Treasury would want to pay).[iii] Lew concurred in 2013, saying, "I think prioritization is just default by another name." (Not true! See previous paragraph.)

Thus far, current Treasury Secretary Steve Mnuchin's position on prioritization's feasibility isn't clear, though he's certainly pro-Congress raising the ceiling. All the back-and-forth aside, evidence suggests servicing debt first isn't just doable-it's mandatory.

This goes back to the Constitution. The 14th Amendment stipulates "the validity of the public debt ... shall not be questioned." Forceful. But vague! However, a 1935 Supreme Court ruling clarifies that Congress's borrowing carries with it the "highest assurance [of payment] the government can give." In short, honoring debt is a priority. But don't just take our word for it: The Government Accountability Office declared[iv] in 1985 that "The Secretary of the Treasury has the authority to determine the order in which obligations are to be paid should the Congress fail to raise the statutory debt ceiling and revenues are inadequate to cover all required payments. There is no statute or any other basis for concluding that the Treasury must pay outstanding obligations in the order they are presented for payment."

Blaming inflexible computer software doesn't fly either. The Treasury admitted in 2014 they're "technically capable" of making debt service payments first.[v] And, recently released Fed transcripts show the Fed and Treasury were already preparing to do so if needed in 2011.

There is no shortage of funds. The Treasury can roll over debt principal even after hitting the ceiling, as replacing existing debt doesn't increase the total. Interest payments are the kicker and easily covered. Monthly tax revenue dwarfs monthly interest payments, which ranged from 5% to 29% of receipts during the last 12 months.[vi] That leaves plenty in the till for Social Security, defense, veterans' benefits, Medicaid and Medicare. We aren't suggesting prioritizing payments is a great way to run government for long-merely that a "debt ceiling deadline" isn't an automatic crisis trigger.

Single-party control of the House, Senate and presidency means lifting the ceiling probably happens without recent years' fireworks. But Republican budget hawks could leverage it to oppose Trump's spending plans, or Democrats could try to extract concessions on hot-button issues. Standoffs are frequent (see 2013, 2011, 2004, 1995, 1985, and even 1953) for a reason-what politician doesn't want to be seen as fighting for America's solvency, and cast the opposition as risking it? So gamesmanship, default threats and maybe market volatility might accompany this year's negotiations. But actual default is overwhelmingly unlikely. The debt ceiling is a political construct, so politicking is to be expected.

[i] While the term extraordinary implies they are, well, extraordinary, the measures are fairly mundane accounting moves, like suspending reinvestments of Treasurys in some government employees' retirement plans, or pausing contributions to a fund used to intervene in other countries' currency markets.

[ii] None of which happened when S&P downgraded the US credit rating in 2011.

[iii] Not likely! Granted, we never got to see how they would have responded to prioritization of US debt (since it never happened), but considering Treasury yields fell following an S&P downgrade in 2011, investors weren't exactly running for the hills.

[iv] In all caps, no less.

[v] Humorously, the Treasury official acknowledging their computers could prevent default still equated "default" with missing non-interest payments-which is still not default.

[vi] Source: Bureau of the Fiscal Service at the US Department of the Treasury, as of 3/10/2017.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.